Since taking office, the chancellor has boasted about the low rate of interest on British government debt, now sinking to 2.2%, the lowest since 1899, as panic-stricken financial markets last week gave up hope of economic recovery and instead bet on years of stagnation with attendant stagnating prices. But George Osborne continues to claim that such low interest rates are proof of the effectiveness of his policies, a saving to the taxpayer and – because they represent a generalised lowering of borrowing costs – a substantial stimulus to the economy. He could hardly be more wrong.

Mr Osborne's analysis will come to match other calamitous British policy misjudgments that disfigure our history. Just as generals in 1942 had the guns of Singapore pointed out to sea when the threat came from the Japanese in their rear, leading to a military disaster, so Mr Osborne and the government have their economic guns pointed in exactly the wrong direction. They cling to a wholly incorrect diagnosis of the threats facing the economy and what the response should be.

The lowest interest rates on government debt for more than 100 years are a cause for profound concern. It is because the prospect for economic growth is so poor, when there is so little demand at home and abroad, that government debt, even at astonishingly low interest rates, seems to offer a better reward than investment in company shares. It is a flight from risk and rising unemployment figures added one more validation.

The international investment community plainly thinks that the overhang of private debt across the European and US economies – the legacy of decades of excessive credit growth – is unserviceable and, worse, is sucking governments and banks into the crisis. Policy-makers seem to have no answer except to stick together, recommending measures that will diminish growth prospects still further while fearing the markets' response to any proposal that might weaken their freedoms.

Britain's predicament, as the markets well understand, is the most acute of all. We have more private debt – three-and-a-half times our national output – than any other G20 country; our banks are thus more vulnerable and overstretched than others; and the degree of demand the government is taking out of the economy through its crash deficit-reduction programme is larger and more abrupt than anywhere else. Britain's position is analogous to Japan's in the early 1990s, a country that has now spent nearly 20 years in the economic doldrums trying to deal with its legacy of private debt from the 1970s and 80s. Only successive Japanese governments' willingness to lift public borrowing to compensate for the private debt overhang has kept the Japanese economy alive.

But the Cameron government is not contemplating that, nor measures to relieve the pressure on banks, nor imaginative ways of relieving the private debt burden. Instead, the coalition, is going full speed ahead rather than thinking of cleverer and smarter ways of managing the crisis. The markets' grim verdict is perversely portrayed by the chancellor as an endorsement.

Mr Osborne and Mr Cameron argue that the situation is hardly of their making. The crisis is international, they say, made worse by Gordon Brown's bequest of Britain's largest peacetime budget deficit. The government can hardly be blamed for the colossal strains that threaten the cohesion of the eurozone, nor the reluctance of Germany to accept the leadership role that is central to any solution. Nor can it be blamed for the absurd economic stance taken by the American Tea Party movement that so constrains economic policy options in the US. Its only option is to try to balance the books and do as much as it can to let the private sector drive recovery.

Yet it is this approach, reproduced in both the eurozone and in the US, that is magnifying rather than reducing the crisis. If all countries simultaneously tighten economic policy when their economies are encumbered by huge levels of private debt, the result will be deflation and depression. Some governments' public debts and deficits require tough austerity measures, which makes it incumbent on those in stronger positions to use what scope they have to boost their economies. Despite the government's chilling rhetoric, Britain is in the stronger camp with only moderate levels of government debt. We have options apart from austerity and an obligation to take them.

But to accept such a proposition requires a shift in the way policy-makers conceive of how market economies operate, what they consider the proper relationship between business, finance and the state, and how the pain of adjustment should be distributed. Osborne and Cameron cannot be reasonably criticised for the wider economic conjuncture, but they can be held to account for being among the most vocal cheerleaders for the consensus that brought this mess about – and is making it worse.

Markets need architectures in which to operate best; they do not spontaneously create such architecture or arrive at best outcomes on their own. The government should be developing options for better managed international currency regimes and ideas on what rules are needed to make all financial asset prices less volatile. Instead, when an idea is floated – such as Angela Merkel and Nicolas Sarkozy's Robin Hood tax on financial transactions – the coalition is unconstructive. Markets and the interests of banks must not be challenged.

At home, Britain should be considering a package of radical monetary and fiscal measures to stimulate the economy. For example, even within a regime that requires banks to hold more capital to support lending, there should be short-term derogations to make it easier for banks to boost business lending. And there should be an emergency package of spending increases on public infrastructure accompanied by tax cuts for the moderately and lower-paid to assure business that there will be some demand for goods and services.

Above all, there needs to be a change in the mindset that suffering economies and citizens should be endlessly grateful to wealth-generating business whose privileges are unassailable and whose leaders' incomes should be taxed as low as possible. Instead, there is a mutual dependence between governments, societies and business and it has been in periods when that has been recognised, such as in the 30 years after the war, that capitalism has best prospered. In effect, Mr Osborne and Mr Cameron have to change their minds. If they don't, the chances of the coalition's survival will become vanishingly small, along with the prospects of a sustained economic recovery.